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Maria Bruno: Hi. I’m Maria Bruno, head of U.S. Wealth Planning Research here at Vanguard.

Joel Dickson: And I’m Joel Dickson, global head of Advice Methodology at Vanguard. Welcome to our podcast series, The Planner and the Geek, in which we’ll discuss topics that are important to individual investors.

Maria Bruno:  And we’ll have some fun along the way. So, Joel, welcome back. We’re in the studio again.

Joel Dickson: So we are!

Maria Bruno: I think we have a fun topic today.

Joel Dickson: Yes? Tell me.

Maria Bruno: We’re talking taxes.

Joel Dickson: Oh! Boy, oh boy, oh boy!

Maria Bruno: I know! I know! I know! I know! No, but kidding aside, I think this is exciting for us because we receive and we welcome questions, comments, ideas for the podcasts; and we have received a number of them throughout this past year, for which we’re both grateful. This helps us formulate the topics that we think about teeing up. And as we went through them, we saw a number of good themes, but what was recurring through all of them was taxes in some sort.

Joel Dickson: Yes. And it’s, obviously, a topic that’s near and dear to both of our hearts and particularly relevant as people deal with really the real-world implications of their own portfolio, the success that they may have with their portfolio and so forth, because at the end of the day, it’s not the amount that you earn, it’s the amount that you keep that ultimately drives your ability to meet your long-term goals.

Maria Bruno: Yes, absolutely. And I think we get in this habit that we think taxes are a seasonal thing, either at the end of the year as we’re starting to try to do whatever tactics we might try to minimize taxes or be strategic in our planning; or during tax season when we’re doing our tax prep during the first quarter. But it’s not. It’s season-less.

Joel Dickson: There you go. But throughout the entire year one thing needs to be thought of in the total portfolio context, yes.

Maria Bruno: I know. And I don’t understand why some people think this is a dry, boring, scary topic. Well, it is scary.

Joel Dickson: Well, it just sometimes can be a little complex.

Maria Bruno: Overwhelming.

Joel Dickson: But it can make a big difference in the ultimate return. I mean you and I both believe that paying attention to the tax implications of investing can provide at least as much return as the investment portfolio itself, and being smart about that and thinking about the opportunities. And I’m sure we will talk about it in the context of the questions as we go through.

Maria Bruno: Yes, and we talk about costs. It’s one of our principles for investing success at Vanguard, right? Keeping costs low. And I often frame it, and you do as well, in terms of costs are two-pronged. One is keeping your investment costs low and the other is taxes because, as individuals, that’s the reality of our investing in financial wellness decisions. So it’s a good important topic. And I joke that it’s scary, but you can break this down so it’s not so scary for people who may be put off by taxes.

Joel Dickson: In my formative years, my advisor at the time, I once asked him how much in taxes he paid relative to kind of his peers, other economics professors, and he said, “Yes, probably about half as much for the sort of same level of income and so forth.” Just because he was really interested and knew sort of the ins and outs of the tax issues with respect to investing and saving.

Maria Bruno: Um-hmm. Um-hmm. So you know a little bit about taxes. You were talking about your advisor. So tell us a little bit more about that.

Joel Dickson: Oh no, I was just going to say that taxes are ultimately are what got me to Vanguard because my dissertation was about tax-efficient mutual fund investing. And Jack Bogle, at the time, and his assistant back in those days—this was the early 1990s—was actually Tim Buckley, who is now our CEO at Vanguard, and they had seen the first paper that we had written on it and basically took it and modified it to create more tax-efficient mutual funds. It’s the lineup of Vanguard tax-managed funds today. So that ended up getting me here, although they constructed the tax-efficient mutual fund lineup without even needing to consult with me before I got here. So, I discovered at the time I learned about writing things way too transparently so that I give away all of the intellectual property at the get-go. But, yes, Mr. Bogle ended up sending me a copy of the first annual report of the tax-managed funds when I was working at the Fed in Washington and it referenced some of the research. And so, in sort of Seinfeld terms, yada, yada, yada, I end up at Vanguard.

Maria Bruno: Here we are.

Joel Dickson: Yes. But taxes are close to your heart as well too, right? I mean in many ways, that’s one of the key distinctions between thinking about an investment portfolio and thinking about financial planning or meeting one’s financial goals, wouldn’t you say?

Maria Bruno: Absolutely. And I can see how it’s transformed over the years as well where there was a lot of focus on tax-efficient portfolio construction, which is very important. But we talk about this in terms of your whole financial wellness, taxes touch different aspects as well. So there’s choices that you can make—whether you’re saving or spending—in terms of how to minimize your tax liability and how to be tax smart. And then actually in looking at some of the questions, we did get some questions around that as well. So how you piece it together, certainly, impacts taxes either what you pay today or how you make decisions that may impact your flexibility down the road.

Joel Dickson: So, Maria, I think just in terms of a level set as we get into the questions a bit, what do we mean by tax-efficient investing? I think we probably need to define that term a little bit.

Maria Bruno: Yes, I think some investors think it’s minimizing the taxes that you pay, but when you think about investing and investing choice, it’s maximizing your after-tax return; and that can be different.

Joel Dickson: Yes, and how that might look. I also talk about it being not just picking tax-efficient investments but being a tax-efficient investor. So you’ve got a great let’s say tax-efficient investment, and it doesn’t give off a lot of capital gains taxes or other tax liabilities, you’re holding it in a taxable account, but then you trade it in response to market returns every three years with mutual fund, ETF, whatever the individual securities, whatever it might be.

Well, any tax efficiency that you might have gotten before now you’ve just given up on your own. So even though the investment itself might be fairly tax-efficient, your behavior turned it into a tax-inefficient vehicle through your own trading behavior.

Maria Bruno: So, we’re recording here towards the end of 2018, and we had major tax reform. And our listeners and all of us are gearing into the first tax prep season with this new tax reform. I think it might be helpful to touch upon a few key things that we may be looking at as we prepare our tax returns and, also, what to think about or what impact, what this means for investors in terms of some of the changes that we saw this year?

Joel Dickson: Yes, you mentioned earlier on about how we tend to think of taxes in a couple of buckets, at the year-end and kind of at the beginning of the next calendar year because that’s where there’s some investment and contribution things that come into play. But this year is a little bit different, that is 2018 than 2017, because of the tax reform package that was passed at kind of year end, 2017. And at a high level, we’ve got lower income tax rates, the elimination of the alternative minimum tax, which often was kind of an additional tax for some, mostly higher-income investors, but it was creeping down into middle income areas in certain cases; and then the limiting of itemized deductions. And people have probably heard the term SALT and, hey, it’s not something you put on food, it’s the deduction that you would get for state and local taxes that you pay that you could get then as a deduction on the federal level. And that’s been sharply curtailed under the new rules.

Maria Bruno: Right, so it’s capped at $10,000 for those that itemized.

Joel Dickson: Right, exactly. But some of that is offset by the fact that the standard deduction was effectively doubled.

Maria Bruno: Yes, I think that’s a big one.

Joel Dickson: Yes.

Maria Bruno: So the standard deduction was effectively doubled and then the personal exemption goes away.

Joel Dickson: Right, exactly. So, all that means is that there’s some trade-offs about lower tax rates but not as many kind of deductions, at least for those that had a lot of deductions in the past, they could be somewhat limited. The biggest changes in some ways are ones that it would take a whole podcast or more to talk about, which is for those that happen to own their own businesses, there are a lot of significant business tax changes that could affect people. And if you’re in that situation and you’re wondering how your tax situation may fare because of it, definitely check with your accountant. Hopefully, it’s a good accountant that understands all of the nuances of the different sole proprietorship rules that changed and how you might best take advantage of those.

Maria Bruno: And if I could add probably two more to that, one would be Roth conversions. So the ability to recharacterize Roth conversions has gone away. So you can still recharacterize contributions. So if you realize that you made too much within the tax filing deadline to disqualify Roth contribution eligibility, you can unwind that. But for conversions, there was flexibility there to be able to unwind those conversions up to October 15 of the following tax year. That gave some flexibility in terms of the ability to do recharacterizations, but that’s been eliminated. And then the other thing, which I’m not sure how often it does come up, but for those that do have minors with custodial type of accounts, the ”kiddie tax” has changed. The limits still apply in terms of the first level of income is tax-free, second level is taxed at the child’s marginal rate, but anything beyond that used to be taxed at the parents’ marginal rate. It’s now taxed at the trust and estate tax rates, which the high marginal rates creep in much, much lower. So it doesn’t necessarily impact a lot of investors, but those that still might have custodial accounts and they’re not zeroing in on this, there could be a little bit of an aha moment.

Joel Dickson: Right, and the marginal rates having changed are those rates that apply to another dollar that you would earn over and above what you currently earn. So those tend to change over time. They get higher as you earn more dollars. The other big change was around estate tax issues.

Maria Bruno: Oh yes.

Joel Dickson: And that was actually a fairly big change that the exclusion amount for estate and gift tax was, again, doubled to a little over $11 million, which basically means a lot fewer people may be subject to the estate taxes. Now a number of these provisions may ultimately sunset or revert back to what they were, but that’s kind of in the plan for the end of 2025, so who knows if that will actually occur.

Maria Bruno: No, but I think that’s an important point that there is a sunset provision. What will happen, we’ll see. But nevertheless.

All right, so I think we covered the big highlights from the tax reform this year. I think it’s a good idea to segue to some questions.

Joel Dickson: Go for it.

Maria Bruno: So our first question, we got a question from Matt from Cary, Illinois, and he asks, “How do you balance attaining portfolio growth with tax efficiency?”

Joel Dickson: So, I think that gets back to the concept of tax minimization might be one strategy but, really, when you think about your total portfolio, you want to be maximizing your overall after-tax return and again, that concept of being a tax-efficient investor. And in many ways, we think that often starts with maximizing tax-advantaged account savings. So it’s not just saving or it’s not just that tax efficiency only matters in a taxable account. It’s that you can get a better after-tax return if you maximize or think about how you contribute across a 401(k) plan if you have one, are eligible for one, traditional IRA, Roth IRA, college savings 529 plans, health savings.

Maria Bruno: Health savings accounts.

Joel Dickson: See? I could read your mind on that one. But there are a number of tax-efficient structures that can provide significant ability to save in a more tax-preferenced way where year-to-year tax issues really are not relevant for an investor. And so, in many ways, that’s the most tax-efficient way to invest is maximizing those tax-advantaged accounts.

Maria Bruno: Yes, I think the tradeoff though is that they come with some restrictions. So there may be penalties to access some of those monies during your pre-retirement years. So I think that then leads to tax diversification.

Joel Dickson: It can.

Maria Bruno: Right, so the importance of having different account types is because they are inherently taxed differently; both with how the accounts are funded, whether it’s pretax or after-tax dollars, how the account grows, whether it’s tax-free or tax-deferred depending upon how you use the money. But I agree with you. Maxing tax-advantaged accounts is a prudent first step.

Joel Dickson: Well, and I think a very good example of that is traditional IRA or traditional 401(k). You get a tax deduction on the way in, but you have to pay taxes on the way out. Again, subject to the rules and restrictions. Roth IRA or Roth 401(k) is the opposite. You pay tax going in, in terms of the contributions, but again, satisfying certain criteria, you don’t pay tax when you withdraw the money, including on the earnings. So, in one case, you’re subject to current tax rates, in another you’re subject to future tax rates. There’s a nice diversification thing just like if you’re invested in U.S. stocks and international stocks, or stocks and bonds in your investment portfolio. Why? Because we don’t know what the future holds, and it diversifies that risk of having all your eggs in one basket.

Maria Bruno: Right. So as a follow-up to that, we had a question around asset location. What is it? How important is it?

Joel Dickson: Yes, this term “asset location.” And that’s really just about how you think about allocating your investments across different account types to maximize the tax efficiency or the after-tax return.

Maria Bruno: Right, but, first and foremost, you need the different account types to be able to then locate the assets. So if you have all your eggs in one basket, in mostly taxable accounts for instance, or even if you have primarily tax-advantaged accounts, there’s limited opportunities because you just don’t have the different account types to be able to then be strategic in how you locate.

Joel Dickson: Yes.

Maria Bruno: So that’s another benefit of tax diversification.

Joel Dickson: Agreed, although we can get into a little bit of a debate here because I think sometimes people will hear, “Oh, well, I want to take advantage of asset location, therefore, I’m going to forego contributions in a tax-advantaged vehicle and start contributing in a taxable account.” And unless there are liquidity needs where the tax-deferred or tax-advantaged vehicles might cause constraints for you, that may not necessarily be the best decision and you need to evaluate that because oftentimes it would still be better for long-term portfolio growth to have the assets all in tax-advantaged accounts if the constraints don’t bind you from meeting your goals. Because, in essence, the difference between a tax-advantaged account and a taxable account, in the tax-advantaged account, you’re only getting taxed once assuming you use it properly. In the taxable account, you’re getting taxed in order to save and then there may be ongoing tax liabilities. So, you’re, in essence, being taxed twice.

Maria Bruno: No, I agree with you. I think I was just trying to make the point that the asset location decision is secondary to the tax diversification story.

Joel Dickson: Yes. But just because you don’t have a taxable account, doesn’t mean that you’re not taking advantage of maximizing the after-tax total return.

Maria Bruno: Correct.

Joel Dickson: So, Maria, when we talk about asset location, how do investors implement an effective asset location strategy?

Maria Bruno: Well, at the highest level, it would be to shelter any tax-inefficient investments within these tax-advantaged retirement accounts. These are things like taxable bond funds or ETFs, things that generate a lot of current income that would otherwise have been taxable within nonretirement accounts. Or things like actively managed equity funds that may generate a lot of income or capital gains, for instance. By holding these things in the tax-advantaged account, then you’re deferring that current income taxation. And then that allows the nonretirement accounts to be more tax-efficient with investments such as broad market index funds or ETFs that are in and of themselves highly tax-efficient.

Joel Dickson: And then to the extent that there’s still any bond exposure, that might mean for higher-income folks, then muni bonds could also be part of the taxable account or tax-exempt bonds.

Maria Bruno: Correct.

Joel Dickson: Well, I think that about higher income or higher wealth portfolios actually leads into the next question that we have. Wanda, one of our clients asks, “Is tax-efficient investing only for people with large portfolios?” How would you address that?

Maria Bruno: No. Next question.

Joel Dickson: How about why?

Maria Bruno: No, a tax-efficient investing is important for investors at every level because, again, you want to try to minimize the amount of taxes that you’re foregoing currently. We talked about this being a cost. If someone is in a higher marginal tax bracket, then yes, they may be paying higher rates, but nevertheless, that doesn’t mitigate the fact that someone at a lower tax bracket should still keep a focus on keeping taxes low in the choices that they make today and then also setting that up for down the road.

Joel Dickson: Yes, this gets back to this thing about, it’s maximizing the after-tax total return and, again, not necessarily minimizing taxes; it matters across the board. There’s a story, I don’t think I’ve told the story on the podcast yet, but now I will. Years ago, probably 15 or so years ago, we regularly—and, Maria, you and I will remember this fondly—we regularly did what’s called “Swiss army” here at Vanguard. And Swiss army is when people that aren’t usually on the phones, get on the phones during heavy periods of call volumes, often in tax season. But I do remember very vividly a woman from New Jersey, who I happened to answer the phone, and she’s talking about wanting to take some money from her portfolio. And this woman was in her mid- to late 80s. And I’m looking at the account and I’m asking her some standard suitability screening type questions like, “What other investments do you have?” and so forth, because all that I was seeing on the screen was that she had one tax-exempt bond fund of roughly $20,000 or $30,000; I forget at the moment. But one tax-exempt bond fund and that was her entire portfolio at Vanguard. So I was sort of inquiring about other places where she might have assets or what other assets she might have. And she said it was only Social Security and then this that she had. And I’m sitting here questioning, wait, but you must be in pretty much a 0% tax bracket.

Maria Bruno: Because she didn’t want to pay the taxes on that bond fund.

Joel Dickson: She didn’t want to pay any taxes on the investment.

Maria Bruno: Right, that’s a common example.

Joel Dickson: That is kind of like a “cutting off your nose to spite your face” type approach because by being in a taxable bond fund, if you have a very low tax rate, you’re going to get a better after-tax income yield from that portfolio than you would from the muni bond portfolio in most circumstances. But it was interesting because at the end of the day, she’s like, “No, I just don’t want to pay any taxes.” I’m like, “Oh, okay.”

Maria Bruno: Yes. And that gets into the taxable equivalent yield in terms of, “Am I better off on an after-tax basis in a municipal bond fund, for instance, or a taxable bond fund?” And we actually have a calculator on, I’m just going to put in that plug, that you could go in and look at that at the fund level as well.

Joel Dickson: Yes, to be able to compare those.

Maria Bruno: Right. And the only other thing I will add on this one, and then we can move onto another question, would be we talk about young investors and the benefits of Roth contributions for young investors, for instance. There’s a situation where individuals presumably are in a lower tax bracket than they would be later. So it is important to be tax-efficient and make those choices. So just by being conscious in terms of how you direct your contributions, for instance, making a Roth contribution, you may be paying taxes on those dollars today, but the account grows tax-free. And then later in retirement when, presumably you, hopefully, would have a much larger portfolio and potentially a higher tax bracket, you don’t have to pay taxes on those distributions. So it’s important at any level.

Joel Dickson: Oh, it definitely is. And this concept of tax alpha or the amount of extra return, if you will, that you can generate through tax-efficient behavior of different sorts, it may be the number of tax alpha may be higher or lower depending on your tax bracket or tax rate. But the existence of it is positive regardless of whether your portfolio is large or small.

Maria Bruno: Yes, it’s interesting because we use this term tax alpha, but it’s not a number that you can go see anywhere. But it’s that making tax-efficient decisions that will save tax dollars, which can equate to a type of alpha.

Joel Dickson: So another question related to some of the things that we’ve already talked about a bit, but I think we can expand on is Al from Texas asked, “Can you ignore tax efficiency in tax-favored accounts like IRAs?”

Maria Bruno: Well, that’s an interesting question because, we had talked about this earlier, when you make investment choices, location type decisions, and how you invest in tax-advantaged accounts, you shelter that current income taxation, but the account either grows tax-deferred or tax-free. So, yes, you might be able to ignore it for now, for instance, if you’re in a traditional 401(k), a traditional tax-deferred type vehicle. But later when you go to make withdrawals from these types of accounts, the entire balance would be taxed at your income tax rate at that point in time. So I don’t think you can ignore it. I think you need to be mindful in terms of how the account will be taxed down the road, if at all. And then, also, the other decision I think you can think through is, are you taking full advantage of those types of accounts during your working years?

Joel Dickson: Yes. And my guess is Al is probably asking it from the standpoint of, a particular investment in that type of account, do I need to worry about that investment’s tax efficiency? And to a certain extent, no—

Maria Bruno: No.

Joel Dickson: Because there’s no annual sort of tax liability. But you’re exactly right, which is, as we’ve talked about, that may just be part of an overall savings and investing strategy in a total portfolio. And then how it interacts with other parts of the portfolio you probably want to take into account.

Maria Bruno: All right, good. So, we have another question from Ava. “Please explain how to differentiate tax-efficient funds from those that are inefficient.”

Joel Dickson: So, again, this question tends to be focused more on the individual investment level, but the main driver of tax efficiency as we think about it at the investment level, tends to be the underlying strategy that is used by that vehicle—fund, ETF, whatever it might be. And so is it a muni bond fund, for example, that invests primarily in tax-exempt or tax-advantaged bond investments? Now how that interacts with your particular state, it may be federal tax-exempt, but you may be still taxed at the state level so there’s additional complication there. But whether it’s an index strategy or an active strategy because typically, active strategies, all else equal, will tend to have less tax efficiency or throw off more in terms of annual tax liability, because there tends to be more trading behavior. As a manager is trying to outperform a particular market segment, they may churn the portfolio a little bit more. And if markets are generally rising, then that would mean, all else equal, some more capital gains that then have to get passed through to investors and they get taxed on. Even if they haven’t sold that investment themselves, they may get a capital gain distribution that—if they’re holding that investment in a taxable account—would lead to additional taxes. So that’s kind of at the high investment level, Maria. Your thoughts about how this works actually with individuals?

Maria Bruno: No, you’re spot on, but when you think about it from the individual situation, you think about someone who’s in a high tax bracket, he or she may benefit from a municipal bond fund; but somebody who’s in a low tax bracket, for instance, he or she would be better off most likely in a taxable bond fund. So it’s that decision-making overlay that individuals need to make for their own personal situation. All right, so just an add-on here which I think tees up nicely, we’ve got Tag from Apex, North Carolina, “Can you compare the tax efficiency of mutual funds to exchange-traded funds?” This screams Joel Dickson.

Joel Dickson: Yes, I did spend a decent amount of my career talking—

Maria Bruno: Okay, but we’re going to timebox you.

Joel Dickson: Oh shoot, I’m timeboxed.

Maria Bruno: Because you’ll spend the whole podcast just on this topic.

Joel Dickson: Oh yes. This would go on for two or three hours.

Maria Bruno: Lightning round yourself. Go ahead.

Joel Dickson: Lightning round! This is one of those things that I think is overblown with the comparisons that are often made between mutual funds and exchange-traded funds or ETFs.

Maria Bruno: Because the…

Joel Dickson: Because the “F” in ETF stands for fund. That is ultimately, ETFs—their legal, their regulatory, their tax rules are basically the same in most instances as mutual funds. A lot of times, the efficiency comes from what we were just talking about, whether it’s an indexed approach or an active approach. And the vast majority of ETFs are actually index-based strategies, while the vast majority of mutual funds are actually active strategies. And that often is, in many ways, the guiding principle. Now that said, there are some structural differences with ETFs that make the use of certain tax strategies a little bit more advantageous in ETF format, and that is basically how folks interact with the portfolio. Because in an ETF, oftentimes they’re traded on what’s called the secondary market. So, it’s one investor, you Maria, selling your shares of an ETF to me, who wants to buy them, and there’s a market maker in the middle, but basically, you and I exchange shares and there’s no impact on the underlying portfolio. Then, when there are impacts in the underlying portfolio, they’re often done with what’s called an in-kind transaction or done with the actual underlying securities in the portfolio instead of in the form of cash. For mutual fund vehicles and ETFs that use in-kind transactions, the fund doesn’t have to realize a capital gain on those transaction which then means it doesn’t have to distribute any capital gain to shareholders based on those transactions. To the extent that ETFs can institutionalize that a little bit more than mutual funds, you do tend to see that ETFs have fewer distributions than traditional mutual funds. But, again, from an index standpoint, that tends to be driving it more than the ETF structure.

Maria Bruno: Well, a lot of good stuff, but I would direct our listeners to to learn more about that as well.

Joel Dickson: Or they can just email you, right?

Maria Bruno: And then I’ll just forward it to you and say, “Joel, this is for you.”

Joel Dickson: So, Maria, we’ve been talking about individual investments and different types of accounts and more kind of the savings piece and the longer-term investing piece. There’s the other side of this, which is how do you think, not necessarily about saving, but about withdrawing? And, in fact, Scott asks, “What is the most tax-efficient way to withdraw from my retirement accounts?” How do you handle that with clients?

Maria Bruno: How much time do I have to answer this question?

Joel Dickson: I don’t know. You timeboxed me with the ETFs.

Maria Bruno: I know.

Joel Dickson: So this is your favorite topic too.

Maria Bruno: All right, I would say, first and foremost, for those individuals that are over 70-1/2 that have tax-deferred retirement accounts, they must take their mandated distributions. So that’s a no-brainer. Take your RMDs first if you need to. If you don’t, there’s a penalty for doing so that’s pretty steep. So beyond that, if you need to spend from the portfolio, the common rule of thumb is to spend first from taxable accounts because any withdrawals would be taxed at capital gains rates that are lower than ordinary income tax rates; and then spend from tax-deferred accounts and then leave the Roth accounts for last. They’re tax-free, the most growth potential there. That’s a common rule of thumb.

Joel Dickson: There are a lot of assumptions embedded in that, right?

Maria Bruno:  There are, and the one that we talk about a lot is it assumes that you are looking to—and these are common spending rules of thumb that are out there— to make sure that the portfolio is not depleted within a 30-, 35-year time horizon, for instance.

Joel Dickson: In other words, the scenario of the idea is you’re going to bounce the check at the funeral.

Maria Bruno: Yes, I was going to let you say that because it’s not as funny when I say it.

Joel Dickson: But that’s not the way that oftentimes a lot of people think about it.

Maria Bruno: No and many retirees don’t. Many retirees have a multi-goal retirement framework, for instance, where they may want to do some gifting or maybe some legacy or variable spending and things like that. And, most likely, the tax situation throughout retirement may change as well. One thing that we talked about tax diversification. For individuals that have large tax-deferred balances, come 70-1/2, these RMDs can be quite sizeable and you may have limited flexibility there. So what I often talk about is the sweet spot between age 60 and 70 before required minimum distributions start. Those actually may be some years where you might want to look at accelerating some income because presumably you may be in a lower tax bracket. So be strategic in terms of if you don’t have that tax diversification, try to build that either through withdrawals from tax-advantaged accounts or maybe even Roth conversions.

Joel Dickson: Yes, I would just add that this rule of thumb does need to be evaluated overall in the context of individual circumstance, as you’re saying. And oftentimes where this shows up is, for example, if you have a legacy goal, if you want to leave some assets to heirs and so forth, the so-called step up in basis at death where, if it’s held in a taxable account there may be no capital gain tax required, at least based on the date of death. That can be a significant advantage that in some ways can flip this withdrawal order if you have that objective.

Maria Bruno: Absolutely.

Joel Dickson: So, it’s something you have to really consider and think about.

Maria Bruno: Right, you need to think about what your goals are and then how your assets are positioned to meet those goals, both from an asset allocation standpoint but also from a tax standpoint.

Joel Dickson: So a similar type of question about tax-efficient sort of structuring of the portfolio and transactions comes from Jeff who asks, “When rebalancing assets across my portfolio, how can I minimize taxes while maintaining my desired asset allocation?” How do you think about that question?

Maria Bruno: Well that’s a fun one and that’s an important one. So rebalancing is important. We’ve written a lot and talked about that as well in terms of maintaining the risk profile of the portfolio. So it’s important to do that, but to do that in a tax-efficient way because if you are making transactions within taxable accounts, you may be subjected to capital gains or even short-term gains that are taxed at ordinary income tax rates. So be mindful of how you actually reallocate the assets. One way to look at it would be if you have tax-advantaged accounts and you can make some reallocation within those tax-advantaged accounts. In essence, those are tax-free because you’re not taxed on any gains or things like that, that you may be changing within the tax-advantaged accounts. We talked about withdrawing from the portfolio, so if you are taking distributions and things like that, do that in a way to rebalance. So, if you’re heavily weighted in equities, which many individuals might be today if they haven’t rebalanced in a while, then pare back on those equity securities first to try to maintain the portfolio. A couple other things I would say would be is if you are directing money into the portfolio, look where you may be underweighted and direct those dollars to the underweighted asset class. So, if you have a lump sum investment that you’re investing, if you are underweighted in bonds, for instance, then put the monies there. Those are a couple thoughts I would have.

Joel Dickson: Yes, in fact, Maria, you’ve written quite a lot about this topic over the years. And I actually think it would be useful to point our listeners to one particular blog post that you did on tax-smart tips to rebalance your portfolio. This was from October of 2017, so it can be found on the Vanguard blog on that talks about a number of these strategies that you would use.

Maria Bruno: Yes. That was a fun blog to write because there’s a couple of other things that you can consider if you’re doing gifting, how to do that if you have a charitable mindset as well.

All right, Joel, thanks for the plug for my blog post. I appreciate that. We have one more question. Steve from Plano, Texas, wants to know, “How do you fix a portfolio that is tax-inefficient?” Is there hope?

Joel Dickson: Yes, there is hope. But it’s actually a really good question because a lot of kind of what we’ve been talking about is assuming that you can just go in and control, pull the lever on asset location or maximizing the tax-advantaged account, or so forth. Fact of the matter is, you may have a portfolio that you’ve built over the years that only now are you realizing or thinking about, “Boy, maybe this isn’t as tax-efficient as I could be after maybe listening to the podcast,” or something like that.

Maria Bruno: Yes. Or like, “Oh wow! My situation has changed. I’m in a higher tax bracket now than I was a couple years ago because either RMDs kicked in or maybe I’m in a lower bracket because I’ve stopped working.”

Joel Dickson: Absolutely. But there is hope because there are a number of things that people can think about to kind of improve the tax efficiency of their portfolio. One, you mentioned in the case of rebalancing, how you can redirect investments in certain ways to more tax-efficient vehicles. So, think about, a lot of times in mutual funds, investors will reinvest automatically the dividends and the capital gain distributions that they might receive. To a certain extent, if that’s a tax-inefficient fund and you’re holding it in the taxable account, in some ways that’s kind of like throwing good money after bad in that, I’d like to improve the tax efficiency but I’m just reinvesting all of these taxable distributions back into that fund that’s going to continue to give me potentially poor tax efficiency going forward. So, instead, if you direct those to a spending account or to another account that is more tax-efficient, that’s one way to slowly get some money redirected in a more tax-efficient vehicle. Second is really using the gifting strategies that you had talked about, which is if you are going to give gifts, instead of doing it in cash, do it in appreciated securities. And if those securities happen to be not particularly tax-efficient, then you’re benefiting in a couple of ways. One, you’re doing the charitable deduction, charitable contribution, potentially getting a tax deduction there, and you’re getting that portfolio that is relatively tax-inefficient out of your overall.

Maria Bruno: Yes. And it doesn’t have to be to a charity either.

Joel Dickson: No.

Maria Bruno: You might have a child or a grandchild in a lower tax bracket. You’re essentially shifting the cost basis of those shares to someone who’s in a lower tax bracket.

Joel Dickson: Yes absolutely. I do think there are other things that also come up. We talked about asset location. There may be things that you can do even today, if you see your portfolio isn’t as efficient as you’d like, that you could switch some things around, for example, in your IRA as you had talked about earlier because there’s not necessarily an annual tax liability from that standpoint.

Maria Bruno: Yes, the one thing I’m surprised we haven’t talked about yet is tax-loss harvesting.

Joel Dickson: There you go!

Maria Bruno: I’m surprised you haven’t brought that up. But I mean the reality of it is with this year, at least as of now, there’s not that many losses to be harvested, which then brings to the point is there cap gains harvesting opportunities?

Joel Dickson: Oh yes. So we could spend a whole podcast on tax gain or harvesting opportunities.

Maria Bruno: I got you there.

Joel Dickson:  There has been some recent volatility in the stock market, at least at the time that we’re recording this podcast, that maybe some folks will see that they have, over the course of the last year or so, some positions that maybe have gone down in value that they might be able to harvest and offset either gains in other parts of their portfolio or even possibly take a tax deduction for some of the losses. It was great to get all of these questions from clients. I think we were able to cover a number of topics around tax efficiency. But, at the end of the day, I think the summary would be that minimizing taxes matter, but don’t lose the overall objective, which is to maximize the overall after-tax return of the portfolio.

Maria Bruno: And there’s two facets to this. One is the tax efficiency of the investment, but then, also, you had mentioned being a tax-efficient investor, so putting that altogether.

Joel Dickson: Absolutely. And we talked in a number of places about rules of thumb, asset location, tax-efficient drawdown, and so forth. But at the end of the day, oftentimes one size doesn’t fit all, and how you do this is going to really be dictated by your own situation and your own goals, and you kind of have to either work with someone. And, certainly, we have resources at Vanguard, either through our website or through even an advised relationship, to help with some of those aspects of thinking about how to be more tax-efficient in your portfolio.

Maria Bruno: And tax diversification matters, right? Much like asset allocation, we don’t know what the future is going to hold. So, having a diversified portfolio in terms of asset classes but then, also, account types is prudent both for the current and the long term.

Joel Dickson: Absolutely. So, we hope you enjoyed today’s episode and that you’ll take a look at your portfolio through a more tax-efficient lens after listening to us. Obviously, to learn more about tax-efficient investing, you can simply search tax-efficient investing on

I also just want to say, before we leave, that in our next podcast, we are planning to talk with our CEO at Vanguard, Tim Buckley, about the vision around Vanguard and the outlook going forward. And just like we were able to really use a bunch of questions from our clients and our listeners today in talking about this topic of tax-efficient investing, if there are any questions that you might have, please do leave us a comment on wherever you might listen to our podcast, whether, iTunes, and Stitcher.

Maria Bruno: Joel, thanks. This really was a lot of fun.

Joel Dickson: Yes, it was.

Maria Bruno: Look forward to the next one. We hope you enjoyed this episode of The Planner and the Geek.  Just a reminder that you can find more episodes of The Planner and the Geek on iTunes and on

Joel Dickson: Or simply subscribe to our series and you won’t miss an episode. And please don’t forget to rate us on iTunes. Your ratings will make it easier for others to find us when they’re looking for investing podcasts. Please join us next time for another episode of The Planner and the Geek.


All investing is subject to risk, including possible loss of principal.

Although the income from municipal bonds held by a fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could perform worse than the original investment, and that transaction costs could offset the tax benefit. There may also be unintended tax implications. We recommend that you consult a tax advisor before taking action.

We recommend that you consult a tax or financial advisor about your individual situation.

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